118. Economic Theory in Venture Capital, Part 1 (Mark Suster)

*Please excuse any errors in the below transcript

Nick: Today #Mark Suster is kind enough to join us from Los Angeles. #Mark really needs no introduction. But if you happen not to know #Mark, he’s a serial entrepreneur turned venture capitalist, who has done a tremendous amount to increase the transparency of startup fund raising and also build a thriving ecosystem in southern California. He is Managing Partner at #Upfront Ventures, and of course blogs at bothsidesofthetable.com. #Mark, it’s a huge pleasure having you on. Thanks so much for doing it.

Mark: Thank you, #Nick. I’m happy to be here.

Nick: Awesome! Can we just start out with sort of your background, your story and how became involved in venture capital?

Mark: Sure. Very simple. I started young in my life as a computer programmer. It was just a hobby of mine. I studied economics but my first job out of undergrad in 1991 was as a developer. And it’s what I wanted to do. And I think it’s become a cool trendy thing to do post the film Social Network and the rise of Facebook and the rise of a lot of startups. It was not very cool in 1991. But it’s what I, it’s what I enjoyed doing. I was a programmer and then I did system design, database design, I did overall system design and architecture. And then I became a specialist in computer networks. I started rolling out networks before there was a world wide web. And I moved to Europe in 1995 to help telecommunication companies and governments and equipment manufacturers prepare for the internet. I did that till ’99. And in ’99, I caught the bug, started my first company. I’ve built and sold two startup companies. I have raised, god it must be 75, 80 million dollars across those two companies. And been through multiple rounds of funding. I’ve been raising money in really booming markets like ’99-2000. And I raised them in pretty tough markets like 2001, 2002 and 2005. So I guess I’ve seen multiples paths of trajectory. My second company I sold to #salesforce.com. I was VP Products at #salesforce.com. And I had the opportunity to switch sides at the table and move over to the world of venture capital. So that’s how I got the idea to create a blog called #Both Sides of the Table. Because I really wanted to write about my journey as an entrepreneur and what it was like from that side of the table. But I realized that I had unique vantage point, which was I was now on the other side proverbially. And I learned a lot about how the other side views entrepreneurship. And so I really try to provide perspectives from the perspective of someone on both sides of the table.

Nick: Sure. And then your transition into venture capital, was that, that was first with #GRP and then with #Upfront?

Mark: So, #Upfront is #GRP. So I joined in 2007. The firm was created in 1996 by my partner #Yves Sisteron. And when I join in 2007, it was called #GRP. We rebranded it as #Upfront because #GRP didn’t stand for anything anymore. It originally stood for Global Retail Partners and we were neither global nor retail. And we set out to create a brand that we thought was important for venture capital. We want to be, back to my computing days, wizzywig, what you see is what you get.

Nick: Sure

Mark: We want to be transparent. We want to give you real feedback, meaningful feedback. We want to not hide behind, you know, the usual things VCs hide behind. Like, “Oh, what a lovely business! If it could just have a little bit more traction. Come see me when it has a little bit more traction.” And I just kept thinking well, what the * is traction? Like how do you find that out? Like lets just be a bit more direct about things. We also wanted a lay out that we want to be early in people’s funding cycle. So being #Upfront represented that. So we created a set of brand principles for what we wanted to stand for. And then we went in search of a name that would support who we think we are and what we want to be.

Nick: And then your focus area at #Upfront, is there a way that you divide responsibilities between the partnership? And is it sector based or, or theme?

Mark: Sure. I’m Managing Partner. So I have a dual responsibility of strategy operations and investment across all of our investment partners. You know, anyone can do really what they want. They can choose a theme that they’re interested in. But people try to stick pretty close to what they know. So, you know, #Greg Bettinelli, who is a partner of mine, was at #eBay for many years. He was the business sponsor of the acquisition of #StubHub. They were second most, second best  acquisition that they’ve done after #PayPal. Then he moved into the world of ticketing and then ultimately became CMO of a startup called #HauteLook, which was bought for several hundred million dollars by #Nordstrom. And he was a hands on practitioner. He understood how customer acquisition work and branding and, you know, he rose through the era of learning how to do social media acquisition, tv acquisition, SEO, SEM, what not. And so he sticks pretty closely to marketplace businesses. He’s very interested in sports and sports related businesses, and e-commerce. So examples of places he’s invested are #GOAT, I don’t know, do you know #GOAT?

Nick: No I don’t.

Mark: #GOAT is one of the fastest growing marketplaces in the country. #GOAT is a millennial terminology. So I suppose I’m supposed to tell you it’s on Fleek or whatever.

Nick: Greatest of all time, right?

Mark: Yes, greatest of all time. So maybe it was an original reference to Michael Jordan, so maybe that’s near and dear to you’re current environments. But it’s a sneaker marketplace for sneaker heads.

Nick: Is that right?

Mark: And a place where you can get authentic shoes that have been validated by the company. It’s peer to peer like eBay was. So it’s people selling shoes to other people. We have famous people on there. We have basketball stars selling their shoes. We have everyday journey men selling their shoes. We have collector shoes. We have, you know, stuff that’s more affordable. But it’s I think amongst the fastest growing marketplaces now in the country. Certainly the biggest and fastest growing in the sneaker head marketplace. And, and I only mentioned it because that’s just an example of you take someone like #Greg, who loves sports, who loves marketplaces, who has a marketing prowess. And he partnered with a team of really extraordinarily young, talented product oriented people. And they’ve built a great business.

Nick: Wow! Shows how far I’m out of millennial fashion, not knowing what #GOAT is.

Mark: I have to tell you that amongst founders and particularly young VCs like everybody knows #GOAT, so if I wasn’t an investor in #GOAT, I can assure you I would have no idea it existed, I’m the least cool fashion person you know. But that’s just because I’m 48, so I just don’t track these younger changes.

Nick: Awesome. Well, in that line of discussion here today, I would love to kind of put the economics hat on and, and talk about venture capital through that lens. I know you’ve got many academic roots in economics. And, and you write about venture capital from that perspective often on the blog. So to start out here, you’ve written about a major lesson from #Clayton Christensen’s book, The Innovator’s Dilemma,

Mark: Yep

Nick: which is one of deflationary economics. Can you describe what this means and why it should be a focus for startups?

Mark: Sure. Well, it’s not a betread I should tell you that. But if you haven’t read The Innovator’s Dilemma, you really should. It’s very influential on a lot of people in business. And people throw around a lot of terminology from The Innovator’s Dilemma without knowing it. So he coined the term ‘disruptive technology’. And people speak about disruptive technology with no understanding of the underlying principles of it. So he studied, and a lot of this comes across in the, in the book, things like the disk drive market. So when we went from whatever it was, eight inch floppies to five and a quarter inch floppies. From five and a quarter to three and a half inch. When you went from three and a half inch to flash memory. None of the vendors succeeded in the change. And so he sought to answer that question of why do incumbents succeed and why do new entrants succeed? And what he basically said is the most successful new entry model is competing with non consumption. What do you mean? So if you look at the origins of, for audio files in my era in the 1970s, 1980s, everyone had hi-fi speakers, really high quality. And the people who produced those were able to spend so much on R&D making them better, that new entrants had no chance, the CapEx requirements for new entrants wouldn’t have worked. And along comes a company that develops a product that goes over your ears called the Sony walkman. And audiophiles laughed at it and the industry laughed at it because the fidelity is much lower than if you’re listening to these beautiful records with these high quality speakers. But they were selling them to different people. They were selling them to kids. And they were selling them for a different use case, which is not I want to listen to the highest quality in my house but I want it on the road, I want it at school, I want it on the bus, I want it on the subway. And so that’s what he means by competing with non-consumption. And when you compete with non-consumption, usually you’re launching an inferior product. That’s the thing that people need to grasp. It’s not as good because if it was the same level as the existing market, you would have to spend millions and millions and millions of dollars in R& D to get it to that level. So you’re creating an inferior product that’s cheaper and at a lower margin. But what happens is by solving a problem that didn’t exist before, because people couldn’t wrap stereo speakers around their ears and go to school. And by targeting a new class of customer, eventually your product gets better and better. And as it gets better, the market starts to trade down. And that trade down is what’s important because you become good enough that people no longer want to spend ten times, twenty times, fifty times, a hundred times the price point. And you end up creating a much bigger market. So my example is, you know, when I started investing in videos, I, I invested in a company called #Maker Studios, our first cheque was written at a four and half million dollar valuation. We sold it less than 4 years later for $700 Million to #Disney. When I first approached media executives about this thing called #Maker Studios and these videos called YouTubes, everyone in the industry said, ‘oh, yeah right, dogs on skateboards.’ And they said no one wants to watch a video on a mobile phone. And I just said empirically that’s not true. Our cost of production was $100 per minute. When the industry, I joke you not, was spending a $100,000 per minute.

Nick: Wow

Mark: We’re doing a $100, they’re doing a $100,000. And as our costs and our quality got better because we suddenly had more revenue, our costs went to like $2000 a minute. But, you know, you’re just competing with non-consumption. You’re competing with young kids who want to watch things on mobile device. And frankly on a mobile device, it doesn’t matter that it’s not big budget special effects, because you wouldn’t notice it anyway. And, you know, it, it was one of the fastest growing companies in the era. It was from zero to three hundred and a fifty million dollars in sales, faster than just about any company for that reason. So you’re dealing with bigger markets, smaller margins, smaller price, perceived as inferior but eventually your R&D catches up to the point where you produce a product that people love. The other example is #salesforce.com. Why did it become so successful when #Siebel already existed? And it’s the same reason. I won’t walk you through the whole case but it’s the exact same story.

Nick: Got it. So totally reinventing a market or creating a new market by accessing mass market consumers and completely different use cases?

Mark: Yeah

Nick: Awesome. So, you know, in light of deflationary economics, what are some of the key questions that a founder should ask him or herself about their business?

Mark: Let me start with something I want to kind of put a knife in the heart of this idea that everything needs to be internet scale. When you want to build a business, you don’t need to build the next #Google. You have to ask yourself what do I want to achieve? For some people, that’s creating a really high quality product that might be expensive, that might target a smaller market. Those products need to exist also, right? So not everything needs to be at scale, not everything needs to be deflationary. But what I try to point out to people, I mean, for example, #Chanel, you know. #Chanel is a high quality, expensive product. It doesn’t mean it can’t exists also. But what I try to point out to people is if you want to build something that has massive scale, if you want to build something that grows very quickly and becomes a multi billion dollar company, which means out of the gate, higher risk, less chance of success, more competition, right? So I want to point that out. But if that’s your goal, then what you need to think about is how do I offer a product that will appeal globally to masses of consumers, not right away but over time. How do I keep the cost base so low that I can achieve that level of scale? And through scale comes lower percentage margin but higher overall margin because I have a much larger market. It is what #Google did. It’s what #Google did to the newspaper industry, in a fact wiping out classified ads, which were very inefficient. It’s what #eBay did by creating a two sided marketplace where things could be much cheaper and they take a small margin on top but you have such high volume that it becomes a large business. So if you want to build things at scale, you have to figure out how you’re going to be able to survive at scale, which is very competitive.

Nick: Would that be a case for building simple elegant product solutions with a, a key or a core benefit as opposed to developing something with robust feature sets that can serve a very heterogeneous set of customers?

Mark: Well, let me say this.. what I think it starts with, and why I termed this concept of what #Clayton Christensen talked to my philosophy of deflationary economics is if you can take an industry where they have big profits and where there have fixed prices, and where it’s a really high cost solution. And if you can find a way to offer something that’s significantly cheaper in cost, they simply can’t compete with you. So the example I talk a lot about publicly is storage. In the United States, but the same is true in Europe, but in the United States, the storage market is about $31 billion a year. It’s very fragmented but the largest player is called #Public Storage. They do about $2.4 billion in revenue per year. And I think their market cap is like $27 billion or something like that. But when you think about storage, they actually have to have a physical location in your neighborhood near your house because no one’s going to drive 25 miles to take their stuff to storage. So by definition, they have a high cost, low customer service. I don’t know anyone who likes their storage provider. High cost, low customer service solution. And if you could centralize storage and move stuff to a central facility, not only could I get more utilization because I can have things that I can stack higher, because people don’t, you know, I can stack them with forklifts rather than people trying to get stuff into storage. And I could massively reduce the cost because I’m storing them in a facility that doesn’t have to be in a local neighborhood. There’s no way for public storage to compete because they would screw their existing business. And so that’s the innovator’s dilemma. It’s like if Make Space can launch that, how do the incumbents respond, it is #Blockbuster and #Netflix. You know, it’s like when #Netflix launches, how does #Blockbuster compete? It is #Barnes and Noble and #Amazon. When #Amazon can store stuff in a centralized distribution center, how can #Barnes and Noble like the, the retail outlet becomes an albatross.

Nick: Sure

Mark: And so that’s just an example for you of places where you can provide a higher quality service at a lower price. And I think that’s really what matters. How do you hit scale.

Nick: Yeah, and you mentioned sort of how incumbents have a hard time responding to this. I’ve got my own experiences working for a large corporation and dealing with the difficulties of responding to small and nimble companies as, as they were innovating, you know, with different economics for, for their products. But can you talk a little bit more about why incumbents struggle so much to respond to startups with this approach?

Mark: Well, you struggle because you’ve got, you, it’s very hard to kill your existing business, you know

Nick: Right

Mark: It’s very hard because you have shareholders that don’t want you to do it. And honestly it’s hard because of incentives. Let’s say, for example, let me give you a real world example, let’s say that you’re the CEO of #Disney. Let’s say that you have this product called ESPN and let’s say that you have a carriage deal in which every customer that has direct tv or sorry has satellite or cable, has to pay $5 a month for ESPN whether they watch it or not. Now you’re talking about a business that’s generating millions and millions of dollars of profit. So if you’re the CEO of #Disney, these, these are smart people, right? They’re not dumb. But you’re looking at that and you’re saying okay, I know that 20 years from now that can’t exist, I know from 10 years from now that probably can’t exist. So I know the future’s going to look very different. But am I just going to like stab it in the heart and throw away all this profit and my shareholders will have a revolt because I’ve taken this cash cow and killed it? You know, so I think in a way innovation has to happen. It’s like the barbarians at the gate. So I always tell incumbents when I talk to them, if I were you, what I would do is I would fund competition who’s going to compete with me, and years fund 10, 20, 30 of them. And, you know, one day as those companies start to disrupt you at least you’ll have an equity position in the future. But it’s impossible to do it behind the moat. Right?

Nick: Right. And, you know, I’ve seen these, these graphs of yours where you’re, you’re pitting price versus functionality, and showing what incumbents are doing versus some of these new entrants. What would you advise new market entrants and new startups to focus on when it comes to price versus functionality?

Mark: Well, let me just start with the basics. It’s like for whatever reason, the Silicon Valley mindset over the last 10 years is just launch products and once you’ll launch you’ll figure out whether you have a market or not. And I just don’t fundamentally believe in that. I think yes you can launch innovative products that you think solve a problem. But it’s worth it at the same time if you’re going to put time, energy, resource and money into doing that, is to think about how am I eventually going to monetize? You don’t need to monetize from day one, but how am I going to monetize this? How am I going to make money? And who am I, like, who am I going to serve? How am I going a design a product like #Bill Gross, who’s, you know, created as many innovative companies as anyone I know. He, he basically built the economic engine of the internet because he created the sponsored search category, which #Google perfected. But he built a company called #Overture, which did sponsored search before #Google, and, by the way, sold for I think $1.6 billion. So it wasn’t like a terrible outcome. But, you know, what he said to me is if you really want innovation, you’ve got to be ten times better at something than anyone else in the market. Ten times better. And here’s why. He said if you aspire to a product that’s ten times better, and if it’s an interesting market, assume there’s going to be 5 or 10 other people trying to do it at the same time. That’s just how innovation works. People use the same inputs to say hey, gosh, if there was this thing called airbnb that worked, maybe we could do a dog based airbnb, you know. And of course, there’s going to be 10 people who have that idea at the same time. So best execution ends up, you know, winning. But, so for me when you come up with a concept, you aspire to be 10 times better. And then he says if you’re amazing as a company, at best you’re going to be two to three times better. But 2 to 3 times better, other people in the market massively trying to compete at the exact same time is what it takes to create an amazing company. We’ve funded a company call #Ring. What #Ring does is just a security doorbell. And it uses computer vision to detect when people are in the perimeter around your house. It automatically sets off a camera, so anyone who’s unexpected in the perimeter starts being recorded. It records them when they push your doorbell, and it allows you to remotely answer as though you’re home. Or if you are home and don’t want to come to the door, you know. Or for example, if it’s a woman and she’s got a boyfriend or a husband or a father, you could have a man answer the phone and, you know, make it known that there’s a man in that home. Anyways. So we launched this company and everyone’s like that will never work because there’s #Dropcam. And #Dropcam was bought by #Google and they’re just going to crush you. And the founder who’s insanely talented, #Jamie Siminoff, said, no, we’re building a purposeful product. It’s going to work outdoors. It’s going to provide doorbell like functionality that’s going to be specific use case, which is outdoor perimeter security. And I’ve got a plan for once I launch that, how I then get perimeter cams. So like the general purpose #Dropcam, which didn’t really solve one individual use case, it was kind of a a baby monitor, kind of a nanny monitor, kind of a security monitor, kind of a this, kind of a that. And he crushed it. And it’s now growing much faster, becoming much bigger than #Dropcam ever was. And he’s on his way to building I think a hugely enormous company by solving a problem much better than anyone else solved.

Nick: Wow! So you do you reconcile this, you know, 10x multiple value with, you know, some of the graphs that you share where you’re saying that, you know, incumbents are going to have much greater capability, and that startups should come in at much lower capability than incumbents, you know. How do you, how do you reconcile those two things?

Mark: Well, I guess this way is the incumbent tries to do everything, be all things to all people.

Nick: Yup

Mark: And by doing all things to all people, the overall cost structure is upside down. So they have to charge more. So I’m not saying design inferior products that are terrible. I’m saying solve a narrower use case, or solve the use case for people which hasn’t been solved, right? So,

Nick: Sure

Mark: there’s a lot of people at this really expensive security solution called #ADT. And they pay a lot of money for it. And then they go out and they buy security cameras that cost hundreds if not thousands of dollars. And you have this really expensive monitoring system. So was #Ring better than that from day one? Not a chance. But they weren’t selling to those people because those are the people who live in Beverly Hills or, you know, they live in Hillsboro, and they’re outside of San Francisco like can afford thousands of dollars, no problem. But this solution works for people who want to spend hundred of dollars. I think the main products order amounted to about $250. And do you know how much it is to monitor video per month?

Nick: I don’t.

Mark: $3.

Nick: 3 bucks

Mark: 3 bucks. 3 bucks a camera.

Nick: Mass market potential then

Mark: It, it’s already become a mass market product. They’re already doing hundreds of millions in revenue.

Nick: Wow!

Mark: It’s also a great product.

Nick: Well, good! Well, you know, at a high level, I also wanted to get your thoughts on some of the trade offs between growth and profitability. You know, we’ve got some very strong, strong voices that are, are pitching growth over anything. We’ve got others that are very focused on, on profitability and, and viable business models from the start. Where do you stand on that?

Mark: So, there isn’t one right answer. That’s just the truth. So let me give a framework for thinking about the tradeoff between growth and profits. Investors value growth above all else in general. But over time they have to see a way that it’s going to be profitable growth. So it’s okay to sacrifice short term profitability for long term growth. But I’m going to give you the scenarios where it doesn’t work. And if they believe that at steady state, your unit economics are going to be good. If your unit economics are upside down, it doesn’t matter. So here’s what I mean. Whenever I talk to journalists who don’t understand economics or business, which is many of them, not all of them but many of them, that doesn’t make them bad people. They just haven’t worked through accounting before. They say oh this company is not profitable. And I say okay, well let’s talk about it. If you’re growing very fast and what you really need to do is launch three new versions of your product, you hire a bunch of engineers or product people. If you’re a geographic business, you might expand faster and open new markets. If you’re a software company, you might hire a whole bunch of sales reps. Any time you’re making investment in sales, in geography, in engineering, you’re spending money on what normally a startup company 80% of your costs are people. You’re spending money on people in advance of the revenue that they help you generate. So every year, if you’re adding people, you’re either depressing profits or driving yourself in a negative profitability. And you couldn’t run a business like this unless you have access to capital. Because the only thing that can finance that is capital. Otherwise you have to finance yourself from your own cash flow. So businesses that finance themselves from their own cash flow by definition grow more slowly because you don’t have the dollars to expand as fast. So you want to profitable business in the short term if you don’t have access to capital or if you want to run something that hits profitability faster, but by definition you’re sacrificing long term growth. If you want a business that’s succeeds at internet scale, and if you don’t grow fast, but you’re on to a really important concept, the biggest risk is that capital will back people who do want to capture that big market opportunity faster than you. So you’ll find that all your competitors become very capitalized. And then it becomes hard to compete. So what I always tell people is if you’re going to focus on growth, let’s say there’s a continuum where there’s growth at one extreme and profitability at the other extreme. I’m not saying you have to be at the extreme. But if you end up building #Uber, and you think many billions, tens of billions are at stake, then you’re going to want to grow as fast as you can provided that the capital markets believe you and will support that growth.

Nick: Sure

Mark: If you’re a more human business, meaning you don’t have that same growth property but you’re still growing very fast, you know, just every year’s a trade off between how fast do we want to grow, how much cash do we want to burn, and if you’re so successful that each subsequent round you can raise at much higher prices, then you can play the capital growth game. But I always say like the thing that founders never think about, there’s a term called cost of capital. There’s a cost of capital. If I can raise 20 million and at 80 per year, which is a large valuation, I’m diluting myself by 20%. If I can raise 20 million at a 40 per year, I’m diluting myself by 33%. If I can raise 20 million at a billion dollar valuation, now my dilution’s infinitesimally small, I might as well raise $80 million.

Nick: Sure

Mark: So that’s, that’s the trade off that I want people to understand. And if you are a unique and rare individual who either has the right background to attract that kind of capital or your business if performing so well that you can attract that kind of capital, then you’ll err more towards the growth. And if you are more conservative because you’re, you don’t, you can’t snap a finger and just have really inexpensive capital, then be a little more pragmatic. Grow a little bit more slowly and focus a little bit more, maybe not even on profits but on running a business with a low enough burn rate that financing you becomes easier.

Nick: Interesting. You know, we recently had #Bryce Roberts on the program talking about #Indie.vc and their model.

Mark: Yep

Nick: Have you had a chance to kind of look through that?